When considering how inventory affects profits, most manufacturing companies focus on the cost of making their products. Just as important, however, is the inventory you already have on hand—because it often carries additional hidden costs that impact your bottom line.
Maintaining inventory is a necessary part of manufacturing operations. Without materials on hand, it’s difficult to meet lead times and customer expectations.
Yet the balance between the right amount of inventory and too much is often a struggle. Manufacturers often maintain more inventory than they need to deal with supplier issues, quality concerns, seasonality and on-time delivery. They’re also offered discounts to purchase in bulk even though it may be more inventory than they can use for months to come (or possibly ever!).
Obviously, maintaining some inventory is necessary; the key is to determine how much. The carrying costs of holding inventory are all of the expenses associated with storing it at your facility or keeping it on consignment with a customer. And it adds up quickly.
The first and generally most obvious cost is warehousing expenses. Storing your inventory typically requires space in a building or on property adjacent to the building. The space is paid through either rent or a mortgage payment. While the mortgage payment itself is not an expense, the associated depreciation and interest is an expense, not to mention the cash outflows of the payment itself.
The more space you need, the more rental or mortgage (through depreciation and interest) costs increase. I’ve witnessed many situations where additional space is rented or purchased to store excess inventory, adding even more to the holding costs. You’ll also typically need storage racks, holding areas, security fences, etc.
Salaries can also be a significant component of holding costs. Inventory must be tracked, counted, sorted, moved and secured, and all of this takes employee time to complete. Consider year-end physical inventory counts. The more inventory on hand, the longer it takes to complete the physical inventory which means more salary cost. On a daily basis, personnel move inventory and sometimes have to search to find the pieces they need. There may even be additional staff hired to manage additional facilities.
Utilities and Other Space-Related Costs
Utilities, insurance, and equipment will also increase costs. Additional or expanded facilities require more lighting, air conditioning, etc., which increase electricity expenses. Equipment such as forklifts, computers and more could be necessary to move and track inventory in these added facilities. And of course, all of this must be covered by your company’s insurance—bringing another cost increase into the equation.
Impact on Cash Flows and Capital
Depending on payment terms, purchasing inventory typically requires cash payment even before goods are shipped and payment is received from your customer. Excess inventory can put a strain on cash flows and working capital, thereby requiring use of a line of credit—which also carries interest costs. This can also limit your company’s ability to grow or utilize the line of credit for large customer orders and significant sales increases, because working capital is tied up with excess inventory.
Finally, the cost of obsolete inventory can be significant to a company. Materials become obsolete for a number of reasons.
- You have raw materials for a product that you no longer make, and you have no other uses for the materials.
- A raw material has exceeded its shelf life.
- You have an excess of raw materials that were bought in large quantities to receive a discount from the vendor.
- You have finished products that are no longer in demand from customers and will likely never be sold.
All of these examples represent cash that will be effectively disposed of with the inventory. Even worse, tax deductions are generally not available for inventory until it is actually disposed of or sold.
To put numbers to this, imagine a company with $1,000,000 of inventory on hand, of which 5% is considered excess or obsolete. Let’s assume carrying costs are 10%. That means the company spent $50,000 plus an additional $5,000 on carrying costs for inventory that will ultimately be thrown away. These losses add up over time and can have a significant effect on your working capital.
Ways to Avoid Hidden Inventory Costs
You can improve several aspects of your inventory practices to control (or even cut) these hidden costs. Start by evaluating your inventory needs to ensure that current purchasing levels are appropriate. For example, if you have two months of a raw material on hand and the vendor only requires two weeks to send you more, no additional inventory should be purchased until current levels are down.
You can also look at the organization of your inventory. Would you need less storage space if your materials were better organized? If it’s easier to access, would you need as much equipment or employee time to retrieve and keep track of it? An honest assessment of how you store your inventory can result in lower costs.
Establish a process to dispose of old inventory at least annually (and define what “old” entails). Additional space is often rented or purchased to store old inventory. Having such policies and procedures in place helps reduce employee handling time, space requirements, etc.
Determine if discounts are worth the excess purchases. Are you going to use enough of the inventory in a reasonable timeframe to make the discount worth using cash flows? Look at past purchases and see whether you’ve had to dispose of unused inventory. If you find that this is a regular occurrence, curb the high-volume transactions. Once you add up the money you paid for those materials and the hidden costs of keeping it, that bulk discount likely won’t make up the difference.
Keep in mind that every company is different, so these guidelines aren’t intended to be all inclusive. Discussing such costs with your manufacturing CPA and your internal accounting team can help identify and quantify those costs.
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